Pay-to-Play Rule

January 1, 2012

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On June 30, 2010, the SEC unanimously adopted Rule 206(4)-5 under the Investment Advisers Act in an effort to curb a practice commonly known as pay-to-play. Pay-to-play refers to contributions to political campaigns, which attempt to influence awarding of contracts for the management of public pension plan assets and other government investment accounts such as 403(b), 457, and Section 529 plans. Pursuant to the new rule, RIAs may not receive compensation for providing advisory services to state and local government clients for two years if the firm or covered associates made contributions to individuals and entities involved in awarding those contracts.

By adopting the pay-to-play rule, the SEC left the door open for third-party solicitors, such as broker-dealer placement agents, to solicit advisory business involving government entities and public pension plans. RIAs are permitted to use a third party to solicit government advisory business if the solicitor is registered as either an investment advisor or a broker-dealer and is subject to the SEC’s pay-to-play rule or a comparable regulation adopted by FINRA.

The pay-to-play rule was modeled after the Municipal Securities Rulemaking Board (MSRB) rules which were implemented to curb improper influence in the municipal bond market. MSRB Rule G-37 prohibits a broker-dealer from engaging in the municipal securities business after making certain political contributions. Similarly, the new pay-to-play rule requires RIAs to take a two-year break from receiving payment for services following a contribution to a public official of a government entity, or a candidate for that office, in a position to influence the awarding of an advisory contract.

The Rationale for a Pay-to-Play Rule

Ideally, public pension plans should choose RIAs for fund management based on their qualifications, customer service, and performance returns, not their political contributions. When contributions are a factor in the selection or retention of investment advisors, the most qualified firm may not be chosen or retained.

Unfair selection processes might lead to hiring a less qualified money manager. A public pension plan may pay higher fees to a firm that was chosen as a result of contributions. Furthermore, the public pension plan might be indirectly paying for soft dollar benefits, which the RIA receives.

A significant amount of money is at stake here. According to the Adopting Release that accompanied the pay-to-play rule, public pension plans now represent one-third of all pension assets in the U.S., and contain more than $2.6 trillion in assets under management. According to SEC Chairperson Mary L. Schapiro’s speech in conjunction with the adoption of the pay-to-play rule, state-sponsored higher education plans—frequently referred to as Section 529 plans—hold approximately $100 billion in assets.

How the Pay-to-Play Rule Operates

There are three major restrictions in the pay-to-play rule.

The rule prohibits an RIA from providing advisory services for compensation to a government entity for two years if the firm, certain employees, or executives make a political contribution to an elected official or candidate who might influence the selection process.

It prevents an RIA, as well as certain executives and employees, from soliciting or coordinating campaign contributions from others in order to influence an elected official.

The rule forbids payments by an investment advisor to third-parties for soliciting advisory business from government entities unless they are regulated persons. The term, “regulated persons,” is limited to RIAs and broker-dealers subject to pay-to-play restrictions.

The pay-to-play rule applies to any investment advisor registered with, or required to register with the SEC. Generally, it also applies to any investment advisor permitted to be unregistered, because the firm is exempted from registration. The Adopting Release for the pay-to-play rule states that it was written for addressing situations where unregistered advisors to hedge funds and private equity funds are marketing advisory services to government entities. Although the Dodd-Frank Act now requires many private advisors to register, certain exemptions from registration are still available.

The SEC’s rules implementing the Dodd-Frank Act amended the pay-to-play rule, so that it applies to both exempt reporting advisors and foreign private advisors. Prior to this amendment, the rule applied to advisors either registered with the SEC or unregistered in reliance upon the private advisor exemption. The amendment prevents a narrowing of the pay-to-play rule.

The SEC amended the date RIAs must comply with the ban on third-party solicitation, which was extended from September 13, 2011 to June 13, 2012.

State-registered advisors are not considered a regulated person. The SEC made that decision, because they do not possess regulatory authority overseeing state-registered advisors through recordkeeping and examination rules. The SEC does possess that authority over FINRA. The SEC rule does not, however, preempt state or local restrictions imposed on pay-to-play practices. Furthermore, once a smaller RIA increases its assets under management to $100 million or more, it will be subject to SEC registration and the federal pay-to-play rule.

Assuming an RIA is subject to the pay-to-play rule, it applies to contributions made by covered associates. The two-year compensation break applies, even if the covered associate leaves the firm. Certain contributions made by the covered associate will be attributed to the RIA that hires the individual.

How Political Contributions Are Impacted

The pay-to-play rule does not necessarily ban political contributions, but it does prevent an RIA from receiving compensation for providing services to a government entity for two years after a specified contribution is made. Therefore, the rule certainly discourages political contributions if they are made for the purpose of obtaining a government advisory contract.

The word “contribution” is broadly defined under the pay-to-play rule as making any gift, subscription, loan, advance, deposit of money or any item of value for the purpose of influencing a federal, state, or local election. The term also encompasses the payment of debt related to an election, and includes payment of transition or inaugural expenses of a successful candidate.

Contributions are not always given in cash. If a key employee for an investment adviser works on a public official’s campaign during business hours, these activities are typically viewed as contributions and will trigger a two-year compensatory break under a government contract for advisory services.

Certain contributions are viewed as de minimis. If a contribution is small, there is little danger it will influence an elected official or a candidate who might participate in the award of an advisory services contract. Any contribution made by the firm itself will not be treated as de minimis.

Members of a firm may make aggregate contributions up to $350 per election to an elected official or candidate for whom the individual is eligible to vote. If the individual is not entitled to vote for that candidate or official, the contribution limit is $150. However, the new rule prohibits bundling—the practice of soliciting or coordinating political contributions for an elected official or candidate influencing the award of a government advisory services contract. The rule also prevents an RIA from soliciting or coordinating payments to political parties in order to win a contract from a government entity.

The pay-to-play rule carves out an exception for newly covered associates. The two year ban does not apply if the contribution was made by a newly-hired, covered associate if he or she made the contribution more than six months prior to being hired. There is also an exception made in certain cases if the contribution is returned.

Rules Relating to Unregulated Solicitors

The pay-to-play rule originally prohibited RIAs from paying a third party to solicit government advisory business. In response to significant feedback, the SEC agreed that third-party placement agents can provide important services to RIAs competing for government business. Placement agents help small and new advisors, as well as offshore managers, with marketing services to government clients without incurring higher costs to hire internal marketing personnel. Placement agents enable RIAs to focus on their strength, which is money management not marketing.

The SEC decided to regulate the use of third-party solicitors instead of banning them in the new rule. This allows RIAs to engage solicitors if they are regulated persons subject to pay-to-play restrictions. Regulated persons would be either a broker-dealer subject to the rules of a registered national securities association prohibiting pay-to-play practices, or an SEC-registered investment advisor.

Books and Records and the Pay-to-Play Rule

RIAs were required to create the following books and records by March 14, 2011:

Names, home addresses, and titles of all covered associates

A list of all government entities to which the firm provided services

All direct or indirect contributions made by the RIA over the past five years

Firms must keep records substantiating contributions made by the RIA and any of its covered associates to political action committees, as well as political parties. Even though contributions from spouses or other family members need not be reported, the SEC will be watching out for schemes designed to circumvent the rule’s contribution restrictions.

The Big Picture

Violating the pay-to-play rule can result in serious consequences. Where a prohibited political contribution has occurred, the two year ban on providing advisory services for compensation becomes immediately effective. Assuming the contribution cannot be returned, the RIA must stop charging fees to the government client. In the Adopting Release, the SEC states that to fulfill its fiduciary obligations, an advisor should provide management services free of charge during the time-out period.

RIAs should adopt robust policies and procedures designed to prevent and detect contributions made to influence the selection of the firm by a government entity, even if a firm is state-registered and not subject to the SEC’s pay-to-play rule. For example, an RIA might implement a policy requiring covered associates to validate their political contributions through the firm’s CCO or designee. These policies and procedures should also promote education on pay-to-play issues and require supervisory review for detecting potential violations. In addition, RIAs should address potential pay-to-play problems in the firm’s code of ethics.

It is imperative that RIAs implement specific policies and procedures if they are using registered persons to solicit business from government plans. These should stipulate that a careful vetting of candidates is used in soliciting business. The goal of this review is to determine if the firm and its covered persons acting as solicitors have engaged in conduct that would disqualify them from being registered persons.

Having policies and procedures in place may help an RIA who inadvertently violates the pay-to-play rule. The SEC, upon application, may conditionally or unconditionally exempt an RIA from the rule. Among other requirements to qualify for the exemption, the RIA must have adopted and implemented policies and procedures designed to prevent violations of the pay-to-play rule.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published by The National Underwriter Company/ALM Media.

An attorney and member of the Pennsylvania bar, Les has handled hundreds of consulting and publishing projects for National Compliance Services, www.ncsonline.com, a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several white papers that analyze compliance issues impacting Registered Investment Advisors (RIAs)‎.